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Bankruptcy trumps protection for inherited IRA

The United State Supreme Court issued an opinion on June 12, 2014 in Clark v. Ramekerdealing with a relatively simple issue at the intersection of bankruptcy law and retirement policy. The case dealt with the ability to exempt “retirement funds” as a category of assets from a bankruptcy estate when an individual files for bankruptcy. The question presented to the Court was whether funds in an inherited individual retirement account (“IRA”) qualify as “retirement funds” within the meaning of this bankruptcy exemption. With Justice Sonia Sotomayor writing the opinion, the Court held unanimously that they do not.

This case involved an IRA that petitioner Heidi Heffron-Clark inherited upon the death of her mother. In 2000, Ruth Heffron established a traditional IRA and named her daughter as the sole beneficiary of the account. When Ms. Heffron died in 2001, her IRA (which had a balance of approximately $450,000 at the time of death) passed to Ms. Heffron-Clark and became an inherited IRA.[1] In October 2010, Ms. Heffron-Clark and her husband filed a Chapter 7 bankruptcy petition, and in that process claimed that the inherited IRA (which had a balance of approximately $300,000 at that time) was exempt from the bankruptcy estate. The bankruptcy trustee and unsecured creditors of the estate, who were the respondents in this case, objected to the claimed exemption on the ground that the funds in the inherited IRA were not “retirement funds.” The Bankruptcy Court agreed with the respondents and disallowed the exemption. The District Court reversed, concluding that the exemption covers any account containing funds originally accumulated for retirement purposes, but upon appeal the Seventh Circuit reversed the District Court’s judgment.

The relevant statute in the case is Bankruptcy Code § 522(b)(3)(C), which exempts retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code. While the parties agreed that the inherited IRA is exempt from taxation under one of those sections, the issue of contention was whether the inherited IRA in the hands of Ms. Heffron-Clark constitutes “retirement funds” for purposes of that subsection. Ms. Heffron-Clark argued that the inherited IRA should be exempt as retirement funds because it was set aside for retirement by her mother. The bankruptcy trustee argued that it the inherited IRA was not exempt because it no longer was retirement funds based on the notion that Ms. Heffron-Clark had the ability to withdraw the funds at any time without penalty.

The Court began by noting that the Bankruptcy Code does not define “retirement funds,” and so a normal meaning must be assigned to the term. In ruling against Ms. Heffron-Clark, the court concluded that the ordinary meaning of “retirement funds” refers to sums of money set aside for the day an individual stops working. In the Court’s view, three characteristics of inherited IRAs indicate that they do not contain such funds. First, the holder of an inherited IRA never may invest additional money in the account. Second, the holder of an inherited IRA is required to withdraw money from the account without regard to how far he or she is from retirement. Third, and as noted above, the holder of an inherited IRA may withdraw the entire balance of the account at any time—and use it for any purpose—without penalty.

The Court in essence concluded that its holding was consistent with the purpose of the exemption provisions within the Bankruptcy Code, which attempts to strike a balance between the interest of creditors to recover assets and the interest of the person filing for bankruptcy to satisfy personal needs. In the view of the Court, nothing about the characteristics of an inherited IRA prevents or discourages an individual from using funds within the account for current consumption. The mere possibility that a certain holder of an inherited IRAs can leave it intact until retirement and take only required minimum distributions does not mean that an inherited IRA bears the characteristics of retirement funds. By contrast, the Court notes that allowing debtors to protect funds in traditional and Roth IRAs helps ensure that those debtors will be able to satisfy their financial needs in retirement.

It seems the Court’s holding in this case was widely predicted (although these days any unanimous decision by the Court qualifies as a bit of a surprise). The decision will send estate planners back to the drawing board. Already some planners are suggesting that an individual with significant accumulated funds in an IRA may be better able to protect his or her heirs from creditors by establishing a spendthrift trust and designating that trust as the beneficiary of the IRA balance. Other alternatives may emerge as well.

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